––– a weblog focusing on fixed income financial markets, and disconnects within them

Tuesday, June 21, 2016

GFC 2.0 – Could it Happen Again?

We returned recently from an enjoyable and enlightening trip to Australia.

This post covers some of the recurring themes that emerged from our discussions Down Under. Given NY’s central positioning in the "GFC" (Australia’s initialism for the Global Financial Crisis)
and so many of the subsequent reform efforts, the Aussies were curious to hear our view on whether it can happen again.

With assistance from some graphics and helpful references, we are going to try to answer this question in a short-ish blog.

A recent post by Bruce MacEwen over at Legal Business does a solid job of summarizing a number of indicators suggesting that economies across the globe are failing to respond to monetary stimulus efforts as central bankers would have hoped, and we were asked about many of these same issues. MacEwen ends his post: “I submit that we have positive confirmation of that hypothesis [Growth is Dead] and that our attention has to turn now, if it hasn't already, to the 'Now What?’”

Rather than focusing on what might precipitate a GFC 2 – Mohammed El-Erian recently posted some thoughts on this here – we focus on what has been happening, and whether we might be particularly vulnerable to a shock, major or minor.

In short, the Fed’s response to the first GFC was to expand the monetary base in support of financial asset prices: the "Greenspan Put" which has been handed down to Bernanke and then on to Yellen:

The emerging narrative is that Central Banks around the globe have in quick succession reduced borrowing costs to record lows (over $10 trillion in negative-yielding sovereign debt), stimulating monetary supplies as a temporary measure to buy time and allow economies to recover from the shock of 2008. However, politicians have typically not had the stomach to implement the structural fiscal reforms required for sustainable economic growth … and have simply used the liquidity injection from central banks to borrow additional cash to fund deficits rather than cut benefits or restructure meaningfully.

Furthermore, the other (some would say main) engine of economic growth – private-sector corporations – have more generally retreated from capital investment that would normally be conducive to economic growth. This pullback can be attributed to a range of reasons, from repairing their own balance sheets to an uncertainty in the economic environment that has culminated in their being conservative in their capital planning. The net effect has been an increase in system-wide leverage, with global debt rising to ~240% of GDP at the end of 2014 (from ~200% pre-GFC).

US corporate debt has climbed as earnings have stagnated:

Over at Casey Research they highlight that (non-financial) corporate debt growth is outpacing GDP growth and has now eclipsed the debt-to-GDP ratios seen in each of the past three US recessions. This is not to say it makes another GFC imminent, as the lead time between the increase in corporate debt relative to GDP and previous recessions has varied. Rather, it simply highlights that not much has improved from previous cycles with regard to the amount of leverage in the system.

Now, one might argue that the increase in leverage / debt loads would be sustainable if sovereigns or corporations were taking advantage of record low yields to invest in growth via infrastructure projects or R&D, which would likely be the policymakers’ preference.

However, instead of capitalizing on low borrowing costs to invest in growth, borrowing cheaply has allowed them to maintain a certain level of politically "easy" spending, enabling them to delay making the hard choices. As for corporations’ use of their increased borrowings, Bloomberg’s Matt Levine will often tell us that “people are worried about stock buybacks”... This suboptimal use of borrowings, at least from the perspective of driving revenue growth, has been among the factors leading ratings agencies to downgrade their assessments of corporations’ ability to repay their increasing debt burdens. Only two companies remain with AAA ratings from S&P.

Some may then argue that since the GFC, regulators have learned the lessons of what precipitated the crisis. They have worked to stabilize the financial system through increased scrutiny of banks’ activities, such as the Volcker Rule, and capital planning through annual stress tests such as CCAR – and this rather looks to continue to increase bank’s market risk capital requirements by roughly 40% from pre-crisis levels. However, John Kay’s “Other People’s Money” argues that while the extent of regulation has increased, it is an expansion of a flawed methodology and does not address the fundamental issues within the banking sector: so these capital increases are unlikely to save us.

Further, even if regulators do get the house in order for individual banks, Adair Turner’s “Between Debt and the Devil” argues that one should think of debt as a negative externality akin to pollution. That is, while it may be rational for an individual borrower and lender to come to terms, one must consider the overall amount of leverage in the system, which is not something we are aware of regulators explicitly controlling (yes, the Fed has attempted to limit US banks from underwriting / syndicating leveraged loans where resulting leverage would be greater than 6x EBITDA, though that has simply pushed the underwriting to shadow banks / foreign regulators banks such that the impact on overall system leverage is doubtful). We have only seen individual bank stress tests, and some macro-prudential initiatives around housing markets from our Antipodean friends – so even if banks are individually well capitalized, which we previously said they may not be, it is the overall leverage across the system that should concern us.

With tepid growth across most of the developed world, corporate and government balance sheets more levered than any time before, and interest rates already at historic lows, central banks may have few levers left to battle any further deterioration in economic performance, regardless of the drivers. And drivers there are, from consumer debt growing in worrisome fashion, to debt being sold to insure banks against rogue trades, to one-off securitizations being done to the tune of $6 billion. And the list goes on, in addition to El-Erian's factors mentioned above.

If we agree that our central banks may not be well positioned to play as formidable a role, we would have to hope that structural reforms are in place to allow private institutions and individuals to step in. And that, too, seems hardly to have been corrected since the GFC with, among other things, self-perpetuating vicious cycles still being a problem – in the pricing and rating of securities – during a stressed environment or a liquidity event.

Outside of the central banks, we don't seem yet to have a functioning correction mechanism. So, when asked whether it can happen again, our response has been: "We hope not, but what could possibly go wrong?”